Tuesday was one of those days you remember in Australian equities. It was a day where OneSteel (OST +13%) said they were considering a ‘name change’, ANZ (+0.2%) hit all bidders in its hybrid issue (what is that telling you about funding?), yet a raft of mining services stocks issued results that beat expectations and led to upgrades. It was another day that absolutely confirmed Australia’s two-speed economy and two-speed equity market.
Interestingly, large-caps again underperformed small and mid-caps as investors begin to work out the vast majority of our largest companies lack earnings growth.
The other reason large-caps, particularly banks, underperformed Tuesday was ANZ’s massively upscaled hybrid issue. I suspect many people who bid for large amounts of ANZ hybrids were surprised by getting hit, leading them to either sell equities or take money from cash management trusts to pay for them. The market now suspects Westpac (WBC) to also upsize its issue. I continue to believe all these hybrid issues are competing with Australian large-cap equities for retail money.
The chart of the ASX Twenty Leaders Index (XTL), while volatile, has broadly gone nowhere for two years. It’s even worse on a six-year chart (I will be expelled from the Stockbrokers Union if I publish that one). Without earnings growth, you are betting on price-to-equity (P/E) expansion to drive capital gains. Unfortunately, right now, large cap Australian P/E’s continue to contract to reflect a broad lack of growth.
Shovel or the hole?
Our two biggest overweight strategic bets in Australian equities are in resources and the resource service sectors.
Yesterday there were a plethora of results in the mining services sector that confirm that top-down growth is translating to earnings and dividend growth.
The question from many investors is now, ‘should I own the shovel or the hole?’ That’s a very fair question with mining service stocks continuing to outperform their miner customers.
My answer is you should own both. In my view, the question isn’t about miners versus mining services; it’s really about miners and mining services versus the rest of the east coast industrial market and financials.
Be ready for the bubble
Our strategy is to hold “shovels and holes” – but I must warn you that I suspect a giant valuation bubble will form in the mining service sector over the next 18 months as investors capitalise the peak of the capex cycle.
As growth, particularly industrial earnings growth, gets harder and harder to find in Australia, you will see a wall of momentum money pile into mining services stocks. This is quite a narrow and illiquid road and I expect to see P/E expansion alongside consensus analyst upgrades. Remember, Australia has an ‘industrial bias’, so look for P/E’s well above the miners to be commonplace. They are the ‘have’ sector of the Australian industrial market.
But it’s as a bubble forms and everyone becomes a believer that you actually make your most money as an investor. Yes, I’m aware at some stage in the next 18 to 24 months I will need to press the sell button on this sector, but I believe it will be at substantially higher absolute and relative pricing.
I simply believe the big Australian capital expenditure (capex) spenders – BHP Billiton, Rio Tinto, Fortescue, Hancock and Chevron – are going to keep the capex tap turned fully on. They learned from the GFC that you have to invest through the cycle to get the benefit of recovering prices. None of them blinked about (Greece etc.) and that is why I believe the capex spend forecasts are reliable, yet not yet capitalised into Australian mining services stocks.
Go Australia, Charlie.
Santos Ltd (STO) – Buy
Santos is financially strong and has a clear growth path through PNG liquefied natural gas (LNG) and Gladstone LNG. Rising gas prices and improving technology to extract hydrocarbons from low quality reservoirs creates exciting upside potential for the company through its Cooper basin position. This year we expect to see about 15 wells specifically evaluating the shale potential of the Cooper basin from several industry players. While the results may be mixed, some of the results are bound to be encouraging. Some of the smaller Cooper basin stocks with shale potential have run hard in the last year, which is not the case with STO. The shale theme is exciting and in our view, you get it for free in Santos.
- 12-month price target: $17.32 (up from $15.25)
- Last closing price: $14.31
Austin Engineering (ANG) – Buy
ANG is a heavy engineering business which manufactures, supplies and services mining products for the resource sector. Austin has proven capable of generating significant revenue and earnings growth with geographic and product expansion, recording organic revenue growth in excess of 20% per annum since 2004. This profile has been supported by an aggressive acquisition strategy where necessary ($67 million in two years), generating total compound revenue growth of 41% per annum over the period. Importantly recent investments in Latin America, Indonesia and Australia support further earnings growth through to fiscal 2013.
- 12-month price target: $5.60 (down from $5.73)
- Last closing price: $4.66
Emeco Holdings (EHL) – Buy
The turnaround at Emeco is now largely complete and the business is positioned to benefit from the growth in demand for rental equipment. Emeco has the scope to recycle $100-150mpa of surplus cash flow into the business for growth and there are clear signs this is occurring. The trajectory in Emeco is clear, with an improving return on equity, strong cash realisation, high levels of production-based revenues and further investment in fleet underwriting growth in net tangible assets.
- 12-month price target: $1.39 (unchanged)
- Last closing price: $1.155
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